Decyphering the Paulson Plan

John Needham is explaining the Paulson Plan in his article on Financial Sense. Here are the most meaningful excerpts (emphasis mine):
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Paulson believes that if he sprinkles enough fairy dust (taxpayers’ money) on the lame and the halt of Wall Street, they too can fly again. Bernanke has been reduced to irrelevance as the Fed has shot its ammo and he now wanders around looking like Hank’s lap dog. Just like the dying fairies, the Wall Street icons can only survive if the people believe. Aping the children at the famous play, the cast of Wall Street is now shouting “I believe in fairies” but the unanswered question as the sleight of hand continues virtually unquestioned in main street media and on Capitol Hill today is “Believe in what”?

As the party heads to Capitol hill today with the administration parroting Chicken Little’s cry “The sky is falling”, it has more than a whiff of panic to accompany it. The urgency I suspect is tied to the notion that Hank can stampede Congress into giving him the unlimited powers he seeks so that he can “work it out” as he goes. The “work it out” part relates to Bernanke and Paulson’s assertion that a failure to rapidly approve their $700 billion plan to remove “illiquid” assets from the banking system will imperil the global financial system and harm ordinary Americans.

That is pure spin. Paulson and Bernanke wouldn’t know an ordinary American if they fell over one. Neither have lifted a finger to help beleaguered citizens stuffed into predatory mortgages. Their concern is only the restoration of order in the US banking system and that means capital.

The problem

You see, these “illiquid” assets are not illiquid at all. They, like all impaired assets are sellable at a price, but the asset holders, mainly the shadow banking community of banks, investment banks, hedge funds, monoline insurers, structured investment vehicles (SIVs), conduits, money market funds and thrift institutions won’t take what the market is prepared to pay for these assets. Indeed based on NAB’s total write off of its US mortgage backed CDOs and Merrill’s write down of its mortgage paper we have a fair idea that the broad brush value of the lower tranches of these horrors is between 25% of face value and zero.

And that is only the first part of the problem. The second is that in the push to gear up the profits flowing from these mortgage backed securities, banks and others added leverage to make the model work at the required rates of return. That leverage is generally about 10 times for regulated banks, thirty times for investment banks and more for others. So, if they take a 10% hit on the face value of the security and they have, let’s say 12 times leverage (modest by today’s standards) they effectively take a 120% write down on the value of that asset. Do the sums at a 50%-75% write down and you can see why these guys are staring into the abyss.

In short, if the wider banking system is forced to hold these assets because they can’t accept the market price for them, and if they are finally forced to value them at true market value (and one suspects even the clueless auditors have an inkling by now of what their clients are facing), they will effectively be insolvent or so capital impaired that they will not be able to undertake their proper functions. Indeed many are insolvent now, but nobody is prepared to shout the obvious, that the Emperor has no clothes. With insolvency comes dangerous secrets. UK regulators are just discovering that Lehman’s UK pension fund is light about $200 million. Many major US pension funds were also light on the necessary. And as most like to stuff the pension funds with their own shares, the problem of failing companies and lower stock prices compounds the staff and punters’ risks dramatically.

Paulson’s real job is to restore Capital

Thus Paulson’s brief in making these institutions whole is not just to relieve them of the impaired assets as his public statements assert, but to do so in a manner that leaves the holders’ capital and balance sheets intact, and here is the great lie.

My father once told me in simpler days before CDO squared and other fiscal junk that there were only two ways to make a quid (dollar). Either you bought oranges for less than they were worth and sold them for what they were truly worth or you bought oranges for what they were worth and sold them for more than they were worth.

Paulson has found a third way. He is going to buy this toxic paper for many times what it is worth and sell it to the taxpayer for even more!

Unless he pays the banks somewhere near face value, less a haircut for these securities, the plan is useless. The real plan is to restore capital. And that is precisely what he and Bernanke are plotting. Talk of illiquid assets is just the smokescreen.

In the process he is asking for immunity from judicial review, a very good idea as otherwise he can plan on spending the rest of his natural days in various courtrooms explaining the unexplainable.

The boys are bailing out Wall Street and you are paying the bill for all those multi million dollar bonuses. You are also paying for the negligence or incompetence (it must be one or the other) of all those regulators who knew what was happening but acquiesced to keep the game going. When asked if he thought that executives of companies taking the handout should have some restrictions on their salaries and bonuses, Paulson replied that such action would be punitive. Clearly that is not on his agenda. No accountability and now no consequences.

So the game is to pass the parcel to an entity that can disguise the losses for many years and whose balance sheet is not really up for scrutiny-the US Treasury. Then the boys can get on with their wonderful lives without this undoubted inconvenience.

You might also want to read this post from Mish.